EU/Spain and China Spur Collective Sigh of Relief

The US dollar is broadly weaker. However, after being marked down sharply in Asia it is clawing its way back in Europe. Global equities’ sigh of relief to both the EU-Spain aid and China’s slew of data has sparked among the best gains of the year in the MSCI Asia-Pacific Index (+1.8%), though India did not participate (0.25%) and S&P’s warning that it could become the first BRIC to lose investment grade status will not help. The gains in the Dow Jones Stoxx 600 are on par with Asia. Of note, near midday in London, Spain’s IBEX is leading the charge, gaining more than 3.5%, helped by the 5.25% rally in financials. The bond market reaction is as one might expect, with peripheral bonds trading firm (Spain’s 10-year yield is off 5 bp), while other bond markets are trading softer. Commodity prices are generally higher, with gold and the precious metals lagging.

It is not much of an exaggeration to suggest that the world economy and financial system was on the verge of plunging headlong into an abyss. The most important thing to be aware of now is that an important step back has taken place. The Federal Reserve assured investors that it is prepared to do what is necessary and the latest weekly jobless claim figures were better than expected. The world’s second largest economy cut interest rates last week and the weekend data dump was mixed, and in any event, should bolster confidence in the soft-landing scenario.

The EU made it clear it was willing to lend Spain as much as 100 bln euros to support its banking system, and to do so without the onerous burden that befell the other sovereigns that requested assistance. While it can be argued, and we will, that the amount will likely prove insufficient, and that there are other important implications, such as what will become of Spain’s 12% funding of the ESM, but the most important thing today is that European officials have innovated and responded. In this context, market positioning is vulnerable. 

The correction that began in different markets and different speeds following the disappointing US jobs data on June 1 seems set to continue. There were large and violent moves throughout the global capital markets in May and the momentum cannot be sustained, especially given the improved news stream. 

The US S&P 500 had its best week of the year (though volume was the lightest) after the recent decline that saw it surrender most of the year-to-date gains. In the foreign exchange market, the euro and Australian dollar had led the down move, and speculators at the IMM had amassed a record short position, suggestive of trend followers and momentum traders more broadly. They have led the bounce back. The yen, which outperformed in May, is likely to trade more heavily as the other major currencies correct. 

In addition, the market perceives the Greek election as binary: Either the New Democracy is able to lead new government or Greece is leaving the monetary union. Given the extended market positioning, the uncertainties surrounding what polls have given all the indication of a statistical dead heat, would seem to offer by itself incentives to reduce exposures. 

We continue to believe that the world will not change on June 17. Regardless of who wins the Greek parliamentary election, a new round of high stakes negotiations will be held. The key issue that separates the ND and PASOK on one hand and Syrzia on the other is not whether the infamous memorandum of misunderstanding must be redrafted, but whether the old one can be the basis of the new one. In this respect too, Greece should be encouraged by the broad outline of the Spain-EU. 

The EU’s ability to find a common ground with a prime minister of surprised everyone by coming out of an important international gathering and unilaterally would adopt a deficit target more than 25% larger than the one negotiated earlier this year. 

Chinese shares suffered their biggest weekly decline of the year last week. Even after the PBOC’s unexpected 25 bp rate cut, stocks couldn’t stage a rally because many feared that the rate cut was in anticipation of the weekend data dump. The data were mixed. There are a few highlights, but the key take away is that while the economy is still slowing it remains modest and the jump in both import and exports is also encouraging for East Asia and commodities, such as copper which is near six month lows. Exports in May were 15.3% above year ago levels. The consensus expected no change from the 4.3% pace reported in April. Import rose 12.7% year-over-year. In April they had risen less than 0.5% and the market had expected an increase to 3.0%. 

 Industrial output and retail sales continued to gradually slow. Fixed asset investment was flat (20.1% vs 20.2% in April). It is the slowing in price pressures that create the most room for policy makers to respond to further economic slowing. CPI slowed to 3.0% from 3.4% in April and this is the slowest pace in two years. Producer prices are 1.4% below year ago levels in May for the third consecutive monthly decline. There is scope for additional easing in the coming months.